Suggested Solutions for Econ 50 Midterm 2015

Fanqi Shi
October 27, 2015

Question 1
X D Px
a. For own price elasticity, X D ,Px = Px X D = 41 I( 14 Px +Py )2 Px I 1 ( 14 Px +
Px X D Py
Py ) = Px +4Py
. For cross price elasticity, X D ,Py = Py X D = I( 14 Px +
4P D
Py )2 Py I 1 ( 41 Px +Py ) = Px +4P
y
y
. For income elasticity, X D ,I = X I
I X D =
( 41 Px + Py )1 II 1 ( 14 Px + Py ) = 1. For this demand function, only income
elasticity is constant (or you can say its not constant elasticity, as own
price elasticity is not constant).
b. Notice X D ,I > 0, meaning the demand for X increases as income rises, so
X is normal. Moreover, X D ,Py < 0, meaning the demand for X decreases
as the price of Y rises, so X and Y are complements.

Question 2
a. Notice x and y are perfect complements for Delong with ratio one for one,
so a possible utility representation is U (x, y) = min{x, y}.

b. For perfect complements, the optimal consumption bundle is always at the

kink, or x = y. Together with the budget line Px x + Py y = I, we have
I
x(Px , Py , I) = y(Px , Py , I) = Px +Py
.

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c. The PCC gives the path of optimal consumption bundles as Py varies. Fixing
20
Px = 1 and I = 20, we have x(Py ) = y(Py ) = 1+P y
. Notice Py > 0, so PCC
is given by y = x for x (0, 20).

Question 3
a. This consumer has a strictly monotonic, strictly convex quasilinear preference
(you can sketch the indifference curves to see this). Assume first we have
an interior solution, so the tangency condition applies. Setting M RSx,y =
M Ux Px Py2
M Uy =Py , we get x = Px2 . Together with the budget constraint Px x+Py y =
P
I, we get y = PIy Pxy . For an interior solution, we require x , y 0. This is
P2
only true when the consumers income is high enough, or I Pyx . Otherwise,
y < 0. In this case, the best a consumer can do is to choose 0 unit of y and
spend everything on x, or x = PIx and y = 0. Combining the two cases, we
get: 2 2
( Py , I Py ) I Py
Px2 Py Px Px
(x(Px , Py , I), y(Px , Py , I)) = P2
( I , 0) I < Pyx
Px

b. The indirect utility gives the highest possible utility level at the given prices
and income. So
2
Py + I I Py
Px Py Px
U (Px , Py , I) = U (x(Px , Py , I), y(Px , Py , I)) = P2
2( I ) 12 I< y
Px Px

c. Notice the income is high enough to sustain an interior solution both before
and after the price change. From the derivation in part a. and b., we have
(x(1, 2, 12), y(1, 2, 12)) = (4, 4), U (1, 2, 12) = 8 and (x(2, 2, 12), y(2, 2, 12)) =
(1, 5), U (2, 2, 12) = 7. So it suffices to calculate the bundle after pure substi-
tution effects, i.e. the bundle that gives the original utility level U (1, 2, 12)
at the new prices. We call this bundle (xs , y s ). At an interior solution, the

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 consumption of x does not depend on income, so xs = x(2, 2, 12) = 1. Setting
U (xs , y s ) = U (1, 2, 12) = 8, we get y s = 6, or (xs , y s ) = (1, 6). To conclude,
the substitution effects associated with the price increase is the change in
consumption bundles from (4,4) to (1,6) and the income effect is the change
from (1,6) to (1,5).

Question 4
I
a. Notice both consumers have Cobb-Douglas preferences, so x(Px , Py , I) = 2Px
and y(Px , Py , I) = 2PI y .

b. Yes, I agree. Notice, U K (x, y) = ln U G (x, y), which is a positive monotonic

transformation, so Kelly and Guido have the same preferences.
c. Fixing Px = I = 1, we have x(Py ) = 0.5 and y(Py ) = 2P1 y . Notice y(Py )
takes all values in (0, +) as Py > 0 varies, so PCC is given by x = 0.5
(y > 0).

d. Fixing Px = 1, Py = 2, we have x(I) = I2 and y(I) = I4 . Notice x(I) takes

all values in [0, +) as I 0 varies, so ICC is given by y = 21 x (x 0). To
get the Engel curve, we rewrite I(x) = 2x (x 0).

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e. Notice x and y are perfect substitutes for Kelly, with ratio one for one.
For part c., fixing Px = I = 1, we have

(1, 0) Py > 1
(x(Py ), y(Py )) = (0, P1y ) 0 < Py < 1
(x, 1 x) for 0 x 1 Py = 1

So PCC is given by the union of two segments: x = 0 (y 1) and y = 1 x

(0 x 1).

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 For part d., fixing Px = 1, Py = 2, we have (x(I), y(I)) = (I, 0). Notice x(I)
takes all values in [0, +) as I 0 varies, so ICC is given by y = 0 (x 0).
To get the Engel curve, we rewrite I(x) = x (x 0).

Question 5
a. This is just a standard budget line Px x + Py y = I, or x + y = 100 (0 x
100).

b. For x 50, the budget line is the same as before x + y = 100. For x 50, Px
goes up to $2. If the consumer spends all he has on x, he can get 75 units.

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 So we know the second segment of the budget line goes through (50,50) and
(75,0), which is 2x + y = 150. To conclude, Fanqis (or Santis) new budget
line is given by the union of two segments: x + y = 100 (0 x 50) and
2x + y = 150 (50 x 75).

c. (See the graph below) Fanqi is as well off, while Santi is strictly worse
off. To show this, notice Fanqis (or Santis) new budget set is a subset
of the original budget set, so both of them are weakly worse off. Moreover,
Fanqis original bundle (35,65) is still affordable under the new prices, so
by revealed preference, he is weakly better off. Given Fanqi is both weakly
better off and worse off, he is as well off as before. Next we argue Santi
must be strictly worse off. By strict monotonicity, it suffices to consider
points on the new budget line. Consider first any point (x1 , y1 ) on the
segment 2x + y = 150 (50 x 75). By strict monotonicity and re-
vealed preference, (65, 35) %S (x01 , y10 ) S (x1 , y1 ) (the subscript S means
we are referring to Santis preference). Now consider any point (x2 , y2 ) on
the segment x + y = 100 (0 x 50). By revealed preference, (65, 35) %S
(x2 , y2 ). Assume we also have (x2 , y2 ) %S (65, 35). By strict convexity, we
have 21 (x2 , y2 ) + 12 (65, 35) S (65, 35). Nevertheless, under the old prices,
1 1
2 (x2 , y2 ) + 2 (65, 35) costs as much as (65, 35), so by revealed preference
again (65, 35) %S 12 (x2 , y2 ) + 21 (65, 35), a clear contradiction. We conclude
that (65, 35) S (x2 , y2 ). It follows that Santi is strictly worse off.

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Question 6
3
a. Both types of consumers have the Cobb-Douglas utility, so xA (Px ) = 5Px
and xB (Px ) = 5P2 x .

b. Notice the demand for both types of consumers are strictly positive for any
Px > 0, so we can apply the horizontal sum without any difficulty. X d (Px ) =
144(xA (Px ) + xB (Px )) = 144
Px .

c. Setting X d (Px ) = X s (Px ), we get Px = $12 and X = Px = 12.

d. Notice the price ceiling Pxc < Px , so theres shortage/excess demand in the
market. The units of x consumed are just the quantity the sellers are willing
to sell at the price X s (4) = 4 units. The total demand at the price is
X d (4) = 36, so the excess demand X = X d (4) X s (4) = 32.